Warren Buffett’s Long Bet #illumedati

Hey everyone, it’s Finance Fridays. Today, I’m doing a short detour from my Let’s Gamble posts. In my previous posts, I’ve talked about The Philosophy and Index Funds and how as a Boglehead I believe that is the best way to invest. You may also recall that I mentioned “The Long Bet” between Warren Buffett and a Hedge Fund. Where is that now? Let’s talk about Warren Buffett’s Long Bet.

Stock Photo from: Pixabay

What is the “The Long Bet”?

Well, it was a million dollar bet between Warren Buffett and a Hedge Fund, Protege Partners, LLC.

The bet was relatively simple. Over a ten year period from January 1, 2008 to December 31, 2017, would an S&P 500 index fund outperform a portfolio of hedge funds. This would be based on a net basis of fees, costs, and expenses.

It was all for a good cause, as the million dollars would go to the winner’s charity of choice.

At its core, this was essentially passive investing versus active investingover a ten year period.

Wow… sounds pretty exciting.

You’re right. It is exciting.

A million dollars is a lot of money to just about anyone, except maybe Warren Buffett, considering he’s worth about $76.9 billion right now (Forbes 9-15-2017).

I imagine Warren Buffett made this bet on a whim and then promptly forgot about it.

So… it’s already September 2017, where are things?

Well… Buffett has kind of already won… even without going all the way out to December 31, 2017.

Protege Partners, LLC has pretty much already conceded their loss in this post on Bloomberg from May 31, 2017.

Then 2008 certainly started off all kinds of wrong for Buffett. At the outset of January 1, 2008 and the stock market crash, leaving all your money in the S&P 500, meant you would post significant losses. Hedge funds, being more active were able to to do what they do best… hedge.

The Portfolio of Hedge Funds did beat Buffett’s Index Fund in 2015 with returns of 1.7% and 1.4% respectively.

However, in 2016 Buffett pulled ahead significantly when his Index Fund pick returned 11.9% versus the Hedge Funds 0.9%.

Buffett himself even stated that the “two and twenty” common management fee of hedge funds, which is 2% management fee + 20% profits meant that managers are “showered in compensation” for what amounts to “esoteric gibberish”.

Cutting deep aren’t we?

So what did this long bet demonstrate to us?

This 10 year period included a crash followed by a recovery. Even with a “head start” in which the hedge funds were able to “hedge” during the crash and take less of a loss, it still was unable to beat out the following 9 years where the index fund had better returns for the majority.

This is reminiscent of the old fable of the tortoise and the hare. Slow and steady wins the race.

It would be interesting to see what the the results would have been without the net operating costs figured in (the two and twenty) of hedge funds. Maybe the Portfolio of Hedge Funds would have come out ahead of the Index Fund. However, no hedge fund in the world will actively manage your money without taking something of the top, so it would really just be exercise in curiosity.

Does this mean index funds will always win?

Of course not.

You can probably demonstrate a “good” time period for when a hedge fund or other actively managed fund would beat a passively managed index fund.

However.

I think it will be exceedingly difficult to demonstrate to me a 30+ year period where the same portfolio of actively managed funds would beat a passively managed index fund. The above example is only a ten year period which includes a one year period which is heavily in favor of hedge funds (a crash), and yet the index fund was able to come out on top even only 4 years later.

Of course, you can say we entered into a bull market (up market) right after the crash and so it favored the index fund… and you’d be right. But how many crashes do you think you will see in your 30 years?

Also, you need to remember, the longer the time period, the longer the management fees eat into your gains.

The term for this is “reverse compounding”. Compound interest, earn it or pay it.

I don’t get it… Warren Buffett is an active investor, but he tells people to invest passively… why?

People tend to think Warren Buffett is a wizard. And… for all intents and purposes, he pretty much is.

However, I think it should be understood that at this point, it’s hard for Warren Buffett to lose. He simply has too much money spread across so many strong companies that it essentially impossible for him to take any huge losses.

Warren Buffet owns Berkshire Hathaway which owns parts of a lot of other companies. In that sense, Warren Buffett is pretty much an index fund by himself.

I’ve gotten quite the chuckle out of the responses. The writer picked an epically fortunate moment to make the wager, and still got the heck beat out of him. It’s like spotting someone 30 balls in the first to a hundred pool wager, and they lose 100-70. And then go on to explain why they are still better than you.

No. 1. I am only wrong temporarilyNo. 2. Things went up when they should have gone downNo. 3. It’s unfair that I lostNo. 4. I wish I never made this terrible betNo. 5. Somewhere in the multiverse I am rightNo. 6. Eventually, one day I pray that I’ll be right

If people are incentivized not to see the truth, they will not see the truth.If people are paid to be deluded, they will delude themselves.

All joking aside…

I still believe that this long bet paints a strong argument for index funds as this was a prospective bet.

I don’t even think Warren Buffett could have guaranteed 100% that the index fund would win out after 10 years, since it’s not the “30+ years” most passive investors like to use. However, in true Buffett fashion… he said he was never worried.

“[Losing by 40 points] may sound like a terrible result for the hedge funds, but it’s not a terrible result for the hedge fund managers,” he said. “If you have a couple percentage points sliced off every year, that is a lot of money … It’s a compensation scheme that is unbelievable to me and that’s one reason I made this bet.”

“It’s so obvious and yet all the commercial push is telling you you ought to do something different today than you did yesterday,” he said. “You don’t have to do that. You just have to sit back and let American industry go to shop for you.”

“No consultant in the world is going to tell you just buy an S&P index fund and sit for the next 50 years,” he said. “You don’t get to be a consultant that way and you certainly don’t get an annual fee that way.”